Success or Failure: The Evidence From Style-Rotating Funds

Actively managed funds tout their ability to successfully rotate across styles (such as large-caps versus small-caps and value versus growth) or sectors (industries) and thus outperform passive strategies (such as index funds). It is certainly true that investment styles do move in and out of favor, presenting actively managed funds with an opportunity for asset managers to outperform passive strategies through the use of portfolio rotation strategies. In addition, the emergence of style- and sector-based ETFs has facilitated the ease and affordability of rapid portfolio rotation across styles and/or sectors, and thus improved the implementation capabilities of style-timing strategies.

The question is: are actively managed funds persistently able to add value? Adam Corbett—author of the February 2016 study, Are Style Rotating Funds Successful at Style Timing? Evidence from the U.S. Equity Mutual Fund Market to the body of literature on what is typically referred to as tactical asset allocation (TAA).

Corbett investigated whether U.S. domestic equity mutual fund managers have been able to capitalize on broad style movements through style-rotation strategies, or whether this behavior eroded value. His study covered almost 6,000 funds for the period from January 2010 to August 2015. Style rotation was measured through both a returns-based (using factor regressions) and a holdings-based (using Morningstar style boxes) approach. The following is a summary of his findings:

• On average, fund managers most prominently rotate portfolio exposures across value-growth and size style dimensions, followed by momentum and then market exposure.

• The sample’s average style-timing ability is negative yet insignificant for all style dimensions except value-growth, which is insignificantly positive. This implies that the average fund has no style-timing ability.

• On average, funds that most frequently rotate across stock-size exposures are significantly worse at timing size returns.

• On average, funds that most vigorously rotate across momentum stocks perform significantly worse, at the 5% level of statistical significance, than the most style-consistent funds.

• An inability to time the market, along with the associated costs of rotating market exposures, is shown to be detrimental to the performance of high market-rotating funds.

• About 80% to 90% of U.S. equity mutual funds had no style-timing ability over the sample period.

• Fund managers that engage in style rotation perform worse on a risk-adjusted basis than managers who maintain consistent style exposures.

• The average fund has insignificantly negative stock-selection ability, implying that funds on average are unable to profit from successfully selecting undervalued stocks.

• More than a quarter of all funds exhibited negative abnormal returns. Only about 2% of funds exhibited significantly positive abnormal returns.

Corbett concluded that attempts to outperform through vigorous style rotation are generally detrimental to fund performance.

Corbett’s findings that active management in the form of style rotation and market timing generally is detrimental to shareholder value shouldn’t be a surprise, as there’s a large body of evidence that has come to the same conclusion. For example, in his book, “Investment Policy,” Charles Ellis cited a study on the performance of 100 pension plans engaging in TAA (another name for style/sector rotation strategies) and found that not a single plan benefited from their efforts. Not one. Even randomly we would have expected some to succeed. Yet, none did.

In a recent study, Morningstar found that over the three years ending July 2014, TAA funds gained an annual average of 7.8%, or 3.8% per year behind their benchmarks. In addition, Corbett’s finding that only about 2% of funds exhibited statistically significant alphas is consistent with what professors Eugene Fama and Kenneth French found in their paper, Luck Versus Skill in the Cross-Section of Mutual Fund Returns, which was published in the October 2010 edition of the Journal of Finance. They found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill.

The bottom line is that, while it’s certainly possible to generate alpha using actively managed funds, the evidence keeps piling up that the odds of doing so are not only very low, but have been persistently getting worse. For example, when Charles Ellis wrote his book, “Winning the Loser’s Game,” almost 20 years ago, about 20% of active funds were able to generate statistical significant alpha. Clearly, it’s become much more difficult.

As my co-author, Andrew Berkin, and I explain in our book, “The Incredible Shrinking Alpha,” there are four trends that explain why this is the case: the supply of victims that can be exploited has fallen dramatically; sources of potential alpha have been disappearing as academic research is published that converts alpha into beta (a common factor); the supply of dollars chasing alpha has grown dramatically; and the competition has become increasingly more skillful. These trends have conspired to reduce the odds of outperforming by a relative 90%! And remember, all the above figures are based on pre-tax returns, and for taxable investors the largest expense of active management is often taxes.